As the global economy inches closer to Global Financial Crisis 2.0 or GFC2, the Leadership of the Group of 20 Nations is attempting to head it off at the pass by assembling a Frankenstein coalition of nations willing to underwrite a huge new bailout of ailing banks. Although estimates vary as to the total amount that might be needed, figures from $2.5 to $6.7 trillion dollars have been floated (hat tip to @paulstpancras):

These forecasts — excepting the Times article — are all old: the NPR article is a month old and the other two are from the Spring. So, conceivably, the total could be higher today. And, considering how the leadership of the world usually waffles over exactly how to handle these situations until a bad situation gets worse, the total price tag will continue to increase while some kind of solution is found.

I don’t know about you but I can’t even wrap my head around these numbers. As if the first round of bailouts during the first global financial crisis wasn’t bad enough — these numbers are higher, and even more offensive. Really, we know better. But so little has been done to change the regulatory, economic, political and financial environment that this outcome is virtually inevitable.

Worst yet, another bailout won’t change anything. Well, it might change something: banks and the financial elite who run them will be further emboldened by the wholesale enabling of the politicians and taken even more risks with someone else’s money. And the people who are already struggling to make ends meet will find themselves facing benefit cuts, higher unemployment in recession-oriented economies. That’s because politicians will justify even more austerity in the name of deficit reduction following this next round of bailouts.

But even if the G-20 can conjure up this mind-blogging sum, it still might not be enough. That’s because the system is so volatile, so full of risk, that something unexpected could come out of left field and bust the system wide open before this new bailout is put together.

Then, the problem was toxic mortgage assets. Now, the problem is toxic sovereign debt AND an overhang of toxic mortgage debt. Not only have banks not cleared all the bad mortgages from the housing boom, but they are being sued right, left and center over bad securitization and underwriting practices from that era. Not surprising.

Credit rating agencies are one wildcard; we’ve seen the turmoil that one rating agency downgrade of the US can foster. In this unstable economic environment, an ill-timed sovereign debt downgrade could start a cascade of bank downgrades or write-downs, sending the global economy into a Lehman Brothers style crisis.

And if France losses it’s top-notch credit rating, say goodbye to the AAA credit rating of the European Central Bank (ECB), one of the main entities behind the attempt to save the Euro.

And what about the banks here in the USA? Rumors have been swirling for weeks that Bank of America is in a perilous financial situation, and may need some kind of bailout. BOA or any other large bank failure could start a destabilizing chain reaction impacting other banks and freezing up the bank system internationally.

And that’s not even including the whole issue of credit default swaps, a type of insurance that banks and companies can take out to hedge against default. No one even knows the CDS exposure on sovereign debt or what might happen if a big sovereign, such as Italy or Spain, needed a massive bailout or a systemically important bank did.

Ugh. I’m getting a headache. The longer the situation goes on, the more potential there is for destabilizing events that could blow up the entire system. Sounds like the choices are:

A horrifically expensive bailout that will kick the can down the road a few more years

A financial crisis that will cripple the global economy and all but destroy the TBTF banks

The unknown

None of these alternatives is particularly appetizing. But I’m betting it won’t be too long before one of them is a reality.

When the credit rating agency (CRA) Standard & Poor’s downgraded U.S. sovereign debt on Friday night, it was the financial equivalent of shock and awe. News sites, news shows and Twitter were abuzz with the news. Though the timing of the news was a surprise, coming as it did shortly after the debt ceiling deal, the downgrade of U.S. debt was almost inevitable and one that the credit ratings agencies themselves helped create.

Rather than being the main contributing event to the downgrade, the debt ceiling debacle, which certainly showcased the ineptitude of Congress and the sad state of fiscal affairs in Washington, DC, was just the icing on the cake following a decade of catastrophic financial mismanagement. From what used to be a budget surplus, the US has run up unprecedented budged deficits fueled by tax cuts for the rich and powerful, two wars that show no signs of ending and a wholesale bailout of the very financial institutions that took a leading role in the financial crisis in the first place.

The credit bubble of the early and mid-2000s has been well documented. Fed by a loose money policy from the Federal Reserve and aided and abetted by lenders, mortgage brokers, appraisers, securities firms and credit ratings agencies, the US blew up a gigantic housing and credit bubble. Securities firms packaged mortgages and sold them to investors around the globe, who snapped them up because of their high credit ratings and relatively generous yields. Unfortunately, many of those securities were build around sub-prime mortgages.

In retrospect, we’ve learned that the subprime mortgage market was rife with fraud from beginning to end. Not only were many buyers fraudulently induced to buy homes that they could have never afforded, many criminals also obtained mortgages under false pretenses. Some mortgage brokers and loan officers pushed through mortgages that they knew would never be repaid. Securities firms had a voracious appetite for these mortgages, which they securitized to investors seeking higher yields. Many residential mortgage backed securities were packaged into collateralized debt obligations.

That’s where the credit rating agencies come in. The job of credit rating agencies is to assign a rating that reflects how likely a certain bond issue and bond issuer is to default. The highest rated bonds, AAA, are deemed the safest.

The compensation structure surrounding credit ratings is an inherently flawed one, as the very securities firms that seek the credit rating pay for that rating. Securities firms could, and did, play the credit rating firms off each other in an effort to get the best ratings for their prime and sub-prime mortgage securities.

And that wasn’t the only flaw in the system. In many cases, the credit rating firms didn’t independently verify the information provided to them about the mortgages packaged into securities. In retrospect, it became evident that their models were seriously flawed as far many more mortgages that were ever anticipated went into default.

When the system blew up, beginning in 2007 and into 2008, it seemed like the only path towards rescuing the global economy was a massive bailout of financial institutions. It was that, or see the whole system come down in flames.

Trillions of dollars were poured into that rescue efforts by the U.S. and other Western governments. While this massive transfer of funds from the people and their governments to the banks did succeed in rescuing the banks and the financial system itself, it was a hollow victory. Like an addict in search of a fix, once the global financial elite realized that the system was, indeed, too big to fail, they had no reason not to continue to take massive risks with other people’s money.

While the system was “saved” in a sense, it still isn’t whole. Imperiled by huge sovereign debts created by bank bailouts, Europe is struggling with a crisis that may very well spell the end of the Euro Zone. In the U.S., the budget deficit is swollen by bank bailouts and tax cuts.

This current sovereign debt crisis has the potential to further savage bank balance sheets, as downgraded debt is eventually written down to market value. Some analysts believe that what’s going on in Europe is that continent’s Lehman moment, the tipping point in a crisis that could again spread across the globe, creating Global Financial Crisis 2.0 (#gfc2). Sped by credit rating downgrades, the global financial system is once again heading towards economic armegeddon.

Which brings us back to the credit rating agencies. There’s no doubt that they were instrumental in creating the first global financial crisis which as led, inevitably, to the second one. As they downgrade sovereign debt across the globe, it’s important to realize that these downgrades are a self-fulfilling prophecy in several senses.

First of all, by their involvement in the first financial crisis, they set the stage for the bailouts that are now crippling sovereign governments. Secondly, through downgrades, they are worsening an already bad situation. Downgrades tend to be a vicious cycle which lead to further downgrades. Thirdly, by threatening downgrades unless countries adopt austerity, they are helping kill any hope of economic recovery, which makes more downgrades likely.